What kind of retirement income can you expect if the stock market doesn’t produce the types of returns you’re anticipating? It’s no secret today that retirees are facing many challenges as they move into their retirement years. Longevity, for one, is becoming a real risk multiplier for the Baby Boomer generation since it amplifies the impact of several other risks retirees will face like inflation, cost of healthcare, and market risk. Now, it seems that some Boomers may be building their retirement plan upon flawed market return assumptions as well.
Are you relying on the “The Number”?
One of the most commonly used rules for distribution portfolios, which are portfolios that are now being used to provide income during one’s retirement, is what’s known as the 4% rule. The 4% rule originated from research done by William Bengen, who determined that an individual could safely withdraw 4% of the assets accumulated at retirement, adjust their spending for inflation, and have their portfolio survive a 30 year retirement period. (Bengen used portfolios that adjusted between 50% to 75% stocks, with the remaining percentage in bonds).
Naturally, this rule has helped frame the conversation around how much one needs to retire. For instance, if you’d like to have around $40,000/year in income, adjusted by inflation, the rule of thumb is that you’d need 1 million dollars invested in your retirement portfolio.
Ex: 4% X 1 million = $40,000
It has been over 20 years since the original findings came from that study, and since then, there has been additional research findings:
-Bengen’s original work didn’t account for taxes, advisory fees, or healthcare costs
-Diversification can actually help increase safe withdrawal rates
-Market valuations at the beginning of retirement have a disproportionate impact on portfolio success
Since the original research was formed, there have been many variations of the rule proposed. For the sake of this conversation, we’re going to keep it simple and focus on the philosophy behind the 4% rule and how it may impact retirees today, especially if retiree portfolios do not perform as expected.
History versus Today
There’s an old saying that we hear often in our industry, “Nothing beats the market over time.” The key word in that entire sentence is time. If you look at a long enough time horizon, equity returns can be quite compelling. One of the most serial offenders for abusing this principle is Dave Ramsey. (In the spirit of fairness, I will concede that I like Dave, and I think he is a great motivator in teaching people about the dangers of consumer debt. However, Dave is not a financial planner—something he openly admits.)
For years, Ramsey has promoted that people can invest in certain mutual funds and earn average returns of 12%, backing up his assertion with historical returns from 1926 until the end of 2012. That’s a 90 year time horizon for growth that I’m sure assumes perfect investor behavior; however, I would argue that, for retirees, what matters to them is their time horizon. Specifically, they don’t want to run out of money during their their retirement years. However, if retirees are expecting the markets to do the heavy lifting for them, they may be in for disappointment.
I have seen several different commentaries on this subject over the last year or two, but I’m going to highlight a couple of viewpoints in this post that I found interesting and easy to understand…
Will Boomers Drag Down Market Growth?
In a recent letter to his firm’s clients, Scott Krisiloff highlighted his belief that the wave of retiring baby boomers is going to have a profound impact on financial markets.* He wrote:
In an ideal environment, Boomers would be able to generate returns without having to sell assets. Income received from dividends and bond coupons would be enough. However, this isn’t a normal environment. Today very few if any assets are producing enough income to cover necessary expenses. With the dividend yield of the S&P 500 ETF at just 1.9% and the 10 year treasury yield at a similar level, back of the envelope math suggests that a Boomer would need a portfolio of $2.6 million to generate $50,000 per year in current income before taxes.
It’s my sense that most boomers and their financial advisors have probably not underwritten their retirement with the assumption of a 1.9% return on their investment portfolios though. This means that in order to generate the requisite income, Boomers will have to become sellers of assets in order to produce yield.
To be fair to Mr. Krisiloff, he does assert that he believes the impact of Boomers becoming more income focused will take time to develop; however, he does see it to be a trend that can create drag on overall market growth simply because the younger generations cannot afford to buy the assets as Boomers sell them at today’s valuations. This, it seems, lends itself to downward pressure on asset prices. Mr. Krisiloff goes on to write:
If you’re a Baby Boomer considering or approaching retirement, it’s important to keep in mind that today’s asset prices are inflated. The economic value of a portfolio at today’s levels can not necessarily be taken at face value. Stress your assumptions about the rate of return that your portfolio will generate. And if you have a strong stomach you may want to assume that the true value of your invested portfolio is about 30-35% lower than current levels. From those prices the standard 5-8% growth assumptions are more reasonable. The other alternative, which is the path that we are taking, is to utilize the tax advantages of retirement accounts to sell at these high levels.
If you’d like to read the full post from Scott Krisiloff, you can do it here.
*Scott Krisiloff is the Chief Investment Officer of Avondale Asset Management, a Los Angeles based investment firm.
How Do You Feel about Portfolio Failure?
Another view that I find even more clarifying on this topic comes from the research done by Blanchett, Finke, & Pfau. In their study from 2013, “The 4% Rule is Not Safe in a Low-Yield World,” they found that,
“…if we calibrate bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, the failure rate jumps to a whopping 57%,” which led to the conclusion that “the 4% rule cannot be treated as a safe initial withdrawal rate in today’s low-interest-rate environment.”
Naturally, some would argue that rates are due to rise, and they continued their study as if rates did indeed increase in 5 years and/or 10 years. In the 5 year scenario, the failure rate was still at 18%; and for rate increases that occurred in 10 years, the failure rate was 32%—roughly 1 out of 3 portfolios would fail.
The emphasis for me came with the statement,
“The bottom line is that the current low-yield environment is a retirement income game changer. And hoping that things will get better eventually is a risky strategy”….By relying on 20th century market returns which we may never see again we’re giving people a false sense of security.”
Finke then explains to advisors:
“I think an advisor has to think more carefully about constructing a retirement income portfolio that includes safeguards to prevent disaster if a client runs out of money.*”
As you can see, this topic is becoming more frequently debated and discussed; and fortunately, it’s a subject that will only continue to increase awareness because of the massive number of Baby Boomers retiring every day. Unfortunately, however, there are many individuals who are retiring on the idea that having a set “number” or investment strategy will be a panacea for their retirement income needs.
For this reason, we have chosen at our firm to focus on the cash flow side of retirement and protect income sources first and foremost for our clients. No matter how hard we try, we cannot force the equity markets to cooperate with our goals, but if I ever develop that skill, I promise I’ll tell you. What we MUST focus on is the things we can control—and build our plan to protect our retirement income. Then, we are able to construct portfolios that can give us the best chance for realizing our long-term investment goals.
As more and more Boomers retire and age into their retirement years, effective retirement income strategies will be paramount to their success. This is why social security claiming strategies are becoming an integral part of retirement income planning, and it’s also a reason that annuity income is beginning to see more and more praise in the academic world. Hopefully, this increased demand for cash flow and income security by the retiring Boomers will continue to be a driver of public awareness for the importance of having a comprehensive retirement income strategy and rewire future generations to consider cash flow generation over a specific account balance.